The week of July 25 will be an important week for the markets, with the FOMC meeting on Wednesday afternoon. I noted last weekend that the markets could see a significant decline, and I still think it is likely to happen. Unfortunately for me, it seems my timing got off by a few days as the VIX fell all week.
This suggests that either the market is playing a game or it is extremely complacent, heading into a pivotal week. The VIX Index (VIX) is trading around 23 at its lowest level heading into an FOMC meeting this year. The day before the previous four FOMC meetings in 2022, the VIX closed above 29 each time. So not only is the VIX low before the FOMC meeting, but if it stays at that level or drops, it will be exceptionally low. So either this is a trap that the market is holding for the bulls, or this market is completely underestimating the importance of this week’s FOMC meeting.
Moreover, the VIX is now very oversold and is even trading below its lower Bollinger band, suggesting that the index could be close to a low point and due to a big spike towards the top of its Bollinger band.
No more appeasement measures
One can look to the term structure of the implied volatility of the S&P 500 options to better understand how complacent the market is. Looking at this term structure and comparing the current structure with the Friday before the June FOMC meeting, it can be seen that the existing term structure is significantly lower.
An at-the-money option for the June 15 expiration date had an implied volatility of around 28.5% on June 10. As of July 22, an at-the-money option for the July 27 expiration had an implied volatility level almost 8% lower, at 20.4%. The market doesn’t seem to be taking this week’s event as seriously as it has in the past. Heading into the May FOMC meeting, an at-the-money option for the May 4 expiration date was at 31.9%, bringing the difference in implied volatility between the May FOMC meeting and the June at only 3.4%.
Given the low levels of implied volatility, the market seems to view this meeting almost as a non-event.
The market underestimates the Fed
This complacency may be happening because the market has convinced itself that the Fed is about to pivot, give in and return to its old ways of supporting asset prices. This week’s meeting could change the market’s mind about how serious the Fed is about fighting inflation and that it doesn’t view the economy as weak or heading into a recession.
FOMC Board Member Chris Waller recently gave an interview and was explicitly asked about the potential for a second quarter of negative GDP growth. In this interview, Waller revealed that gross domestic product and gross domestic income diverged and while GDP was trending down, GDI was not. He noted that these two measures of the economy are expected to move in the same direction and believes that at some point GDP will likely be revised up, and perhaps GDI will be adjusted down a bit. . But the strength of the labor market and the GDI figures suggest the economy is not in recession or heading into a recession. He also noted that the negative GDP footprints could be due to export category measures that undermine the performance of the domestic side of the economy.
Looking closer, while real GDP was negative in the first quarter, real GDI rose 1.8%. This suggests that the economy may not have been as weak as the GDP report showed. If the Fed factors in these other factors, such as the GDI when considering the growth and strength of the economy, this could be problematic for a market that now expects a pivot from the Fed.
Ironically or not, this topic came from the GDP and the GDI in the final minutes of the FOMC, with participants noting the mixed signals between the GDP and the GDI regarding the pace of economic growth and the fact that the labor market was very tight. .
Troubling signs for a Fed pivot
Digging deeper, the latest data from the Kansas City Labor Market Conditions Index, as of June 30, showed the index was still at its highest level since the late 1990s.
Additionally, the Atlanta Fed’s wage growth tracker hit a new high in late June. This was its highest level on record since 1997. At this point the tracker has risen vertically and is not yet showing signs of peaking.
Even the Cleveland Fed’s CPI Nowcast projects an annual CPI rate of change of 8.9% in July, which would be just two-tenths of a percent lower than the 9.1 rate of change. % of June CPI.
Meanwhile, the Atlanta Fed’s 12-month inflation forecast is currently at 5.6% and, like many of the indicators mentioned, it is rising sharply and vertically. The last time this index reached such a high level for persistent inflation was in April 1991, when the three-month Treasury rate was nearly 5.7%. The gap between the sticky measure of inflation and the 3-month Treasury bill was last this wide in July 1980.
All of this means that, so far, the Fed has had virtually no impact on its mandate to bring inflation back to its 2% target, and the Fed can find plenty of measures to use to ward off fears of a downturn. growth if they so choose to meet their inflation target.
The other point is if inflation gets as sticky and entrenched as some of these forecasts suggest. Rates may have to go even higher than what the Fed has currently protected, and a few quarters of negative inflation-adjusted real GDP won’t slow them down.
If that’s the message from the Fed this week, then the stock market is not only too complacent, it’s in for a big shock.